10/28/2008 @ 12:00AM

Strident And Wrong

The endless debates on whether the government or the market is “the cause” of our current financial malaise has yet to reach its final resting point. One strident voice in this debate belongs to Jacob Weisberg, writing in Slate. His “big idea” is that the current financial meltdown proves that the End of Libertarianism is upon us.

Let us tremble at this premature death sentence. No fair and balanced account of the current meltdown can dwell exclusively on the failure of government to regulate credit-market derivatives. It must ask deeper questions about the antecedent events that brought credit markets to their knees.

Weisberg offers no such account. Alas, the financial rot started in the underlying home-mortgage market, with the government decision to subsidize home mortgages generally through low interest rates, and compounds the problem by offering special Fannie and Freddie guarantees at the low end of the market.

These foolish decisions prompted market actors to react just as libertarians fear: to profit privately from public foolishness. Savvy lenders looked less to the creditworthiness of their borrowers and more to unwise government guarantees that insulated them from risk. A high-risk loan of $1,000, without that guarantee, could be worth half that sum before the ink was dry. But who cares, if a government agency will pick up the slack?

Similarly, self-interested borrowers eagerly grasped at cheap-money loans, thereby driving up the price of underlying assets. But once these subsidies became too expensive to sustain, the capital markets raised the price of interest, which killed off refinancing for persons living beyond their means.

At this point, securitization, which diversified some risks, accentuated others by spreading the bad paper throughout the entire system. Now the high default rates on mortgages introduced massive uncertainty for valuing these financial instruments, which triggered government mark-to-market re-evaluations–which in turn forced a premature liquidation of assets. And presto, the failure of the Wall Street investment banks mushroomed into a larger financial crisis.

Weisberg is so intent on attacking libertarians as “intellectually immature” that he overlooks the point of this cautionary tale. Private markets magnify government errors. But in light of this history, it is plain foolish to treat the current failures solely as the result of an unregulated market. The hard question is what kind of regulation is appropriate, and why.

Unfortunately, Weisberg is adamant about the need for regulation but clueless about its form. It was just these messy problems of implementation that slowed up non-libertarians like Robert Rubin. How do we regulate derivatives in the U.S., for example, if those contracts could migrate offshore? Indeed, private clearing-houses, as responsible intermediaries, might just outperform government regulation, precisely because they don’t face the territorial constraints of domestic oversight or the Byzantine complexities of multilateral treaties.

Weisberg’s crudest charge, however, is that all libertarians suffer from the incurable dogmatism of high school students captivated by Ayn Rand novels (which–confession–I have never read). His stick-figure image of libertarians does not square with the current intellectual landscape. Limited-government libertarians like me are not anarchists. We have a presumption against government regulation, which can be rebutted by showing long-term social improvements. We know not only about the virtues of competitive markets, but of the challenges posed by asymmetrical information, public goods, prisoner’s dilemmas and market cascades.

Accordingly, we recognize that the specter of bank runs, illiquidity and credit freezes might justify some regulation. In dealing with the current crisis, we have to accept some role for the Federal Reserve as a lender of last resort under our current institutional arrangements. But we are equally adamant that bad regulation can wreck credit markets. And we insist that governments must mend their lending habits to reduce the odds of credit trains going off the rails yet again. We also strenuously oppose using the credit crisis as a lever for introducing all sorts of senseless gimmicks to disrupt labor and product markets.

Weisberg is oblivious to these strands of the libertarian tradition. Pathologically, he overrates market failures and underestimates government ones. So says the indignant, but ever thoughtful, libertarian.

Richard Epstein writes a weekly column for Forbes.com. He is a senior fellow at Stanford’s Hoover Institution and a professor of law at the University of Chicago, visiting this fall at the New York University School of Law.